With the world ravaged by what seems to be a never-ending downturn, a new school of thought is finding currency. This school says that successful Capitalism is not about risk-taking as much as it is about risk management, not about greed as much it is about ethically grounded ambition, not about getting rich as much as it is about changing the world. Proponents of this new school believe that sustainable EPS growth, share price performance, social impact and personal wealth are the by-products of this ‘controlled risk, grounded ambition and global impact’ brand of Capitalism. I have had three sets of experiences recently which have exposed me to this school and I have to confess, I am on my way to becoming a convert.
First, during my three weeks in Doha I heard Nassim Taleb speak for an hour. While he is not one of the greatest of orators, he made a few powerful points:
Economists and forecasters (i.e., people like me) do immense damage by giving point estimates of growth, interest rates, earnings, etc., because such estimates give others a false sense of confidence in the predictability of the future. Since we all know that the future will bring ‘black swans,’ we have to recognise that the future is unpredictable and, therefore, risky. (The fact that we don’t know precisely what type of black swan the future will bring is irrelevant, says Taleb.)
Debt, at every level of aggregation (the individual and the corporate) is ‘toxic.’ ‘There is no safe level of debt’ as having debt immediately increases your downside risk.
Finance has never really come to terms with how much damage debt can cause. Neither has finance understood the ‘risk’ properly. For example, a well-trained financial analyst will say that a company running at 100 per cent capacity with, say, 0.5 debt:equity, is a more attractive investment than a company running at 80 per cent capacity with no debt. Why? Because the former company will, in all likelihood, have better return ratios. However, the latter company is better-placed to deal with risk and with black swans (and we all know that the future has black swans).
Secondly, last week I read Jim Collins’ latest book Great by Choice. In his most thoughtful book to date, he uses 22 years of data and 10 pairs of well-known American companies to illustrate the point that Taleb was making in Doha – that great companies (defined by Collins as those that give you 10x shareholder returns over 22 years):
Take measured risks. They ‘fire bullets’ to see if a certain venture is worthwhile and if the bullet hits its mark; they ‘fire cannonballs’ (i.e., make a big investment).
Plan for ‘everything that can go wrong will go wrong.’ Hence, such companies maintain cash reserves, don’t make big acquisitions (which, if they go wrong, can cripple a company) and consistently work on keeping a ‘Plan B’ in place.
Grow at a controlled, steady pace year after year.
Stick to a well-defined, well-thought-through strategy in a disciplined manner for long periods of time (rather than changing their strategy in response to business cycles and fads).
Collins’ book is a must-read for those whose careers hinge on making bets on Indian corporate houses because my four years in India have taught me that: (a) Very few Indian companies work assiduously to hedge risk and (b) Such companies (which have surplus cash, take measured risks, grow in a steady fashion, have a Plan B in place) are peculiarly unloved by the Indian stock market and hence, are available at bargain prices.
My third defining experience was the ‘Battleships’ project that our team embarked upon three months ago. Given the hammered macro environment and given my view that affordable capital will become increasingly scarce in the years ahead, we set out to find listed companies with strong balance sheets, strong cash flows and well-established franchises which have pricing power. Our quantitative tests over the past six years highlighted that a portfolio consisting of such companies would have outperformed the BSE500 almost every year – both on an equal-weighted and a market cap-weighted basis. Even more surprisingly, most of these companies were not glamour stocks. Their CEOs are rarely seen in the Press as these companies don’t raise equity capital, don’t make big acquisitions and don’t launch new strategic initiatives. They usually do the same thing year after year: Generate a lot of cash and make their shareholders rich. Of our 36 Battleships, here are my favourite five: TTK Prestige, VST, GSK Consumer, Eicher Motors and Titan.
Both in the West and in India as the economic environment structurally changes, as capital becomes scarce, old-fashioned values are gaining credence. As Jim Collins puts it, “fast decisions and fast action is a good way to get killed” in the current environment.
